Shareholder voting rights today
Shareholder voting rights have not been a priority for investors or asset managers. Voting as a shareholder, or proxy voting, is not like voting as a citizen. The structure of index funds separates the shareholder’s decision-making authority from the companies that they own, i.e., the fund’s investors do not have the opportunity to influence or vote on their shares.
The three largest index managers, BlackRock, Vanguard, and State Street, were the largest shareholder in 88% of the S&P 500 companies in 2017.[1] These passive index providers manage 81% of the global passive market, which means that shareholder voting rights are concentrated with three entities: giving them enormous power over the underlying companies without giving them an economic interest in influencing those entities’ decisions.
Knowing the price of everything but understanding the value of nothing
In a passive investment fund, fund managers do not take decisions about which stocks or bonds to hold. An index of available investments determines the portfolio holdings. Retail investors generally prefer passive funds because they are cheaper, performance is easier to understand and many believe that making a return above a market return is very difficult. Retail investors, particularly values-based investors, should be aware that passive funds generally vote with management and do not differentiate across their funds, even in thematic funds, e.g. ESG funds. In 2015, out of 100,000 votes Vanguard, BlackRock and State Street voted the same across their funds in all but 6, 18 and 195 occasions respectively. Contrast this consistency with Fidelity, which has more actively managed funds. Fidelity differed among its funds 3,144 times per 100,000 votes.[2] These statistics show that index providers do not differentiate across their funds nor do they take active stances on key governance or values-based issues. It is very difficult for a passive investment manager to facilitate the shareholder voting rights of their entire investor base so they do not always bother.
Not taking a stance may make sense, after all index managers are hired to hold the index, not take bets on the index constituents. Consequently, very little differentiates passive funds qualitatively or quantitatively, so they compete largely on fees. This situation creates a conflict of interest between the passive fund manager’s governance responsibilities and economic interests. Passive managers operate on thin margins, so they want to incur as little cost as possible. Given the sheer number of companies their funds cover, the passive managers would need large teams to oversee proxy voting at every shareholder meeting to ensure that the shareholder voting rights of their clients were accurately and consistently expressed. In 2017 to 2018, Vanguard had about twenty employees who shared responsibility for researching and voting on 168,786 ballot items, or roughly 8,400 per employee. Similarly, BlackRock employed thirty-six people to analyze and vote on 158,942 proposals or nearly 4,500 issues per employee. Finally, State Street had twelve people on staff.[3]
Share Lending = Vote Lending
In addition to cost minimization, passive managers look for ways to subsidize fees[4]. One approach is to lend out portfolio securities to third parties such as hedge funds. These loans frequently coincide with shareholder meetings and dividend declarations. Lending stocks is a misnomer. What really happens is the portfolio sells the stock to a third party with an agreement to buyback. The sale/buy-back means that all shareholder voting rights associated with stock ownership transfer to the buyer, including the right to proxy vote. Securities lending presents a clear conflict between the passive manager’s economic and governance interests – so how is this conflict managed?
The investor’s best interests vs. maximizing shareholder return
Index providers outsource proxy voting to third parties, again, to control cost. These third-party firms generally have stated purposes to maximize shareholder value versus voting in accordance with a values-based voting policy. The result is that passive managers do not consider alignment to the true shareholders’ values or high-quality governance goals. Analysis has shown that index providers do not vote in alignment with specific ESG factors even in thematic ESG funds. This approach begs the question of how an index manager, who is not asked or paid to make a judgement, should determine what is in the investor’s best interests.
Fiduciary duties as defined in the current SEC rules
Fund managers have a fiduciary responsibility to vote in their clients’, the investors’, best interests. Historically, the SEC interpreted this responsibility as voting on material corporate resolutions. In 2019, the SEC revised its interpretation to allow non-voting when the fund manager deemed it in the best interest of the investor or when not lending the stock represented an incremental opportunity cost to the investor, e.g., forgoing lending fees would increase the fund’s value.
This change had a substantial impact on passive managers’ behaviors. One recent study showed that “…after the SEC clarified funds’ power to lend shares rather than vote them at shareholder meetings, institutions supplied 58% more shares for lending immediately prior to shareholder meetings. The change is concentrated in stocks with high index fund ownership.” [5] The study further showed that supply increased from 15.6% to 22.3% in those stocks. For values-based or activist investors using passive funds, even thematic funds, these results show not only a governance lapse but also a significant hurdle to communicating their values and interests to the underlying companies.
Index investors should have a greater say in how their votes are cast
Options for values-based and activist retail investors to express their views are limited, particularly if they invest passively. Concerned retail passive investors should review whether their fund manager’s proxy voting record aligns with their values. Some tools allow the investor to take concrete actions, such as petitioning a fund manager or a company. Another way for retail passive investors to influence corporate governance and voting is to directly hold shares through direct indexing. While these activities and tools are evolving, retail investors face significant barriers to communicating what they believe is in their best interests and influencing how companies are managed. There is significant potential to change corporate practices if the true shareholders can get the passive managers to vote their shares in alignment with their values.
[1] Jan Fichtner, Eelke M. Heemskerk & Javier Garcia-Bernardo, Hidden Power of the Big Three? Passive Index Funds, Re-Concentration of Corporate Ownership, and New Financial Risk, at 1 (Feb. 2017), available at SSRN: https://ssrn.com/abstract=2798653.
[2] ibid
[3] Griffin, Caleb N., “We Three Kings: Disintermediating Voting at the Index Fund Giants Giant”. Maryland Law Review, Vol. 79, Issue 4, Article 3.
[4] Regulatory filings show that passive managers’ fee income can range from 0-30% of the borrower’s fees.
[5] “The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Trade-off” Edwin Hu, Joshua Mitts, Haley Sylvester, December 2020
